Sunday, November 29, 2009

In a previous article, I conducted a basic analysis of the economy and monetary scheme of Second Life, a three-dimensional virtual world where users can create virtual goods and services and exchange them with one another. I showed that thus far, Linden Lab, Inc., the creator of Second Life, has taken a mostly hands-off approach to its economy, with the notable exception of its fiat currency scheme.

Unfortunately, Linden's aversion to paternalism changed in January with its announcement that it would be banning most interest-paying banks from Second Life. The announcement reads:

"As of January 22, 2008, it will be prohibited to offer interest or any direct return on an investment (whether in [Linden dollars (L$)] or other currency) from any object, such as an ATM, located in Second Life, without proof of an applicable government registration statement or financial institution charter. We're implementing this policy after reviewing Resident complaints, banking activities, and the law, and we're doing it to protect our Residents and the integrity of our economy."

This policy has strong parallels to the adoption of 19th-century banking regulations in the real world. These regulations were supposed to stop wildcat banking, where ambitious bankers expanded credit through risky loans until defaults led to insolvency and left their depositors empty-handed. Similarly, in Second Life, unregulated banks have offered demand deposits bearing interest rates of 40% or more, at least one of which never actually had any loans underlying its interest-bearing deposits.[1] Cases such as that are almost certainly fraud and should be adjudicated as such, but Linden's adoption of a draconian ban on all interest-paying banks, which had been preceded by a ban on gambling, has established a clear pattern of economic interventionism. This does not bode well for Second Life users, for as Ludwig Von Mises has taught us, middle-of-the-road policy leads to socialism.

Who Needs Virtual Banks Anyway?

Strangely enough, there is no need in a virtual world for "banks," in the strict sense of the term. In Second Life and many other virtual worlds, the software interfaces have robust and secure forms of money with integrated payment systems. Unlike the real world, where a bank provides a secure alternative to storing large amounts of money under one's mattress, there is no risk in Second Life of being burglarized or robbed at gunpoint by another avatar. Although there may be some risk of having one's account hacked, a virtual bank is presumably no more secure and is probably a higher-profile target than any one individual.

It is not my intent to quibble over semantics, but it is necessary to identify the actual function of "banks." In the real world, it is to warehouse one's money, but in Second life, the nonfraudulent banks could be better described as either investment funds, where depositors are promised some portion of the yield generated by the fund's investments, or as brokerage accounts that allow depositors to invest among the different stocks offered on the bank's associated exchanges. While some banking institutions offered these services in addition to their interest-bearing accounts, those institutions that do not pay interest appear to be unaffected by the ban.

Wildcat Banking

Banks with no underlying loans and no ability to redeem all deposits, such as the one mentioned before, are essentially Ponzi schemes, and therefore fraudulent. But what about a bank that actually does extend loans, though to the point that it does not have enough reserves to cover all of its demand deposits, i.e., what about fractional-reserve banks? Are they committing fraud? Murray Rothbard explains, in the context of gold being used as money:

"It is true that the note or deposit does not actually say on its face that the warehouse [bank] guarantees to keep a full backing of gold on hand at all times. But the bank does promise to redeem on demand, and so when it issues any fake receipts, it is already committing fraud, since it immediately becomes impossible for the bank to keep its pledge and redeem all of its notes and deposits. Fraud, therefore, is immediately being committed when the act of issuing pseudo-receipts takes place. Which particular receipts are fraudulent can only be discovered after a run on the bank has occurred (since all the receipts look alike), and the late-coming claimants are left high and dry." [original emphasis][2]

The charge against unregulated fractional-reserve banks in the real world was that they would issue more bills of credit than they could possibly redeem and that these bills of credit would circulate as money, leading to inflation, boom, and bust when the banks defaulted on their deposits. That much was true. However, the regulations that were adopted simply sought to limit the fraud to a manageable level, in contrast to a free market, which would have had the tendency to eliminate it altogether.

In the case of Second Life, the prospect of inflation caused by wildcat banks is not a practical concern. I am not aware of any notes issued by a bank in Second Life ever circulating as money. This is because it would be highly impractical for that to occur. As mentioned before, the L$ enjoys a strong competitive advantage over any other would-be moneys because it is part of the payment system integrated into the default Second Life software client. Furthermore, one can be sure that Linden would move swiftly to protect its highly-profitable fiat currency scheme from any competition, just as the federal government raided NORFED for promoting an alternative real-world monetary scheme based on precious metals.

In actuality, the only entity involved in this discussion that is inflating the money supply is Linden itself. Linden has created about US$14.6 million worth of L$ with no backing whatsoever.[3] Although the L$ apparently falls outside the federal government's definition of money (this can be inferred because Linden hasn't been shut down), it clearly functions as a medium of exchange and is very much indeed money. This evasion of the legal definition of money has parallels to the dubious accounting practices that often accompany corporate scandals, where financial statements technically comply with the rules that govern them, but paint a picture that does not reflect reality.

"Rather than being fraudulent, the L$ is simply a terrible solution for its supposed ends…"

A natural question to ask, then, is whether or not Linden is committing fraud by creating money out of thin air and selling it to people for US$. The answer is no — from a natural-law perspective at least. Linden explicitly describes the nature of the L$ in its terms of service and states that they are not redeemable for US$. Reading closely, it even appears that, for all practical purposes, they are actually Linden's property.[4] Rather than being fraudulent, the L$ is simply a terrible solution for its supposed ends, to provide a stable medium of exchange that will allow for a robust and growing economy. Using the L$ is like implementing a monetary scheme during wintertime that uses scoops of ice cream as money. It could work pretty well for a little while, but come springtime, it would result in a huge mess.

As shown above, the fractional-reserve banking occurring in Second Life is not inherently inflationary and would not have led to boom and bust in and of itself. Accordingly, Linden's justification of banning all interest-paying banks in order to "protect the integrity of its economy" is either ignorant or disingenuous (probably the former). The other justification Linden provided was to "protect its Residents," presumably from the threat of fraud, which really means to favor one group (naïve depositors) at the expense of another (lenders, the entrepreneurs whose businesses they capitalize, and all of the consumers who would purchase goods from those entrepreneurs). This favoritism raises some very obvious questions regarding the ethics of the ban.

The Ethics of Virtual Interventionism

For classical liberals in favor of property rights and opposed to any form of interventionism, the question of whether or not Linden's ban should be considered unjust is not as straightforward as it might seem. To make this determination, we must first establish what rights Second Life users have. The basis of my argument will be natural rights, particularly as elaborated by Murray Rothbard in The Ethics of Liberty.

Proponents of natural rights generally hold that one can make an unclaimed, scarce natural resource his property by mixing his labor with it. In Second Life, one can mix his labor with atomistic objects to produce a desirable good. Having created said good, one retains the sole ability (aside from Linden) to reproduce, sell, or otherwise dispose of it. If the story were to end here, it would appear that Second Life users have natural rights over their creations; but alas, it is not so simple. This is because the natural right of property is not derived from the artificial nature created by Linden, but from the nature of human existence in the real world. Although some Second Life users may wish to deny it, Second Life is very much a part of the real world. Stubbornly rejecting this notion will not lead to any benefit, just as one who rejects the idea that the Earth is a sphere will probably never achieve space travel, and one who rejects the idea that water is necessary for human life will surely die of thirst.

Given that goods in Second Life are in fact real, just like a kitchen table or an automobile, it quickly becomes apparent that they are very much like, if not the same as, intellectual property (IP). This observation complicates the discussion because it turns out that there is not a unanimous consensus among classical liberals on whether or not IP constitutes property from a natural rights perspective. Ayn Rand and others have argued that it does. Taking the opposite stance, Roderick Long and Stephan Kinsella have presented lucid and concise arguments against the legitimacy of intellectual property.

Adopting the view that IP is not property, one still runs into problems because goods in Second Life are not pure information; they are specific instances of information. Just as the line of reasoning presented by Long and Kinsella would allow a particular hardback book to be considered property as a scarce instance of information, so too might be the configuration of electrons on Linden's computer servers.

Having stirred the pot of whether or not virtual goods in Second Life should be considered the property of their creators, I leave the reader with perhaps an unsatisfying conclusion: it is unclear.

The uncertainty arises from the complexity of Second Life's terms of service, the fact that parts of the terms of service rely on the unnatural concept of IP as property, and the ultimate ambiguity of whether or not Linden, who owns the servers on which the goods are being created, ever grants title to its users for instances of information on its servers. It might be like a manufacturing plant, where the owner of the plant retains title to the goods being labored on by employees, or it might be more like a pottery workshop where the workshop provides tools, raw materials, and storage, yet the makers of the pots are granted title to their creations. My personal inclination is to say that it is more like the former and that Second Life users do not possess any natural rights over their creations. Consequently, I do not believe any economic intervention by Linden to be fundamentally unjust.

One Lesson for Linden

Linden's ban on interest-paying banks may not be unjust, but that does not mean that it should be condoned. To draw such a conclusion would be to confuse morality with ethics. Just as one might believe, for instance, that it should not be considered a crime to smoke cigarettes, drink alcohol, or do hard drugs, one might at the same time believe that all three practices are morally objectionable and that they would all lead to suffering. So too, I believe that Linden's ban of interest-bearing banks is a poor policy, though I ardently respect their right to adopt it.

I also have some sympathy for Linden in adopting this ban, as it might have been due to pressure from federal regulators. Because Linden falls under the jurisdiction of the United States, it is therefore subject to the threat of coercive force if it does not follow regulators' biddings. But sympathy aside, policies such as the ban on interest-paying banks incentivize further reckless behavior by users who have made foolish decisions, and they frustrate and hinder the entrepreneurs who are producing the goods that attract people to Second Life.

Linden policymakers would do well to learn and memorize to look not merely at the immediate, but at the longer effects of any act or policy, and to trace the consequences of that policy not merely for one group but for all groups.

Matthew Beller is a former employee of the Federal Reserve Board of Governors and currently works for the Securities and Exchange Commission in Los Angeles.

Notes

[1] In a panel hosted by the Metanomics series, one virtual banker remarks around time 19:50 that his bank, which has paid annualized interest rates of 44% and higher, had no loans underlying deposits. Whether or not there were any other assets underlying the deposits that could provide sufficient yield to pay the promised rates of return is uncertain.

[4] As of January 17, 2008, the terms of service read, in part, "You agree that Linden Lab has the absolute right to manage, regulate, control, modify and/or eliminate [L$] as it sees fit in its sole discretion, in any general or specific case, and that Linden Lab will have no liability to you based on its exercise of such right."

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About Me

I am an e-Money researcher and a Founding Director of the Bitcoin Foundation. My career has included senior influential posts at Sumitomo Bank, VISA, VeriSign, and Hushmail.

"Free-market protagonists, such as Matonis, regard cybercash as better than traditional government-issued or -regulated money, because it is determined by market forces and thus nonpolitical in nature." --Robert Guttmann, Professor of Economics at Hofstra University, in Cybercash: The Coming Era of Electronic Money, 2002

"Matonis is quite correct that the new technology makes easier the use of multiple private currencies." --Mark Bernkopf, Federal Reserve Bank of New York, in "Electronic Cash and Monetary Policy", 1996

"Matonis argues that what is about to happen in the world of money is nothing less than the birth of a new Knowledge Age industry: the development, issuance, and management of private currencies." --Seth Godin in Presenting Digital Cash, 1995